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Bad News is Great News for Traders
But even down economic times offer many profit opportunities for smart traders. To profit, traders need to closely watch the macroeconomic reports.
When mid-year adjustments are made to projections, it's important to understand exactly what they mean and to adjust your trading strategies accordingly.
Let's take a look at how to turn the poor macroeconomic picture into profitable trades.
Studying recent news
After the mid-year point in June, the world economy was expected to grow.
The idea was that after the inflation spike wore off and the Japan earthquake faded, that economic growth would improve.
Part of this assumption is correct.
Overall global inflation is trending lower.
And current estimates show the CPI based inflation at 2% from May through July.
This was less than half the increase during the first third of the year.
Japan is also recovering much faster than expected and could see a 7% annualized GDP gain for this quarter.
Still, the problem is that the final economic numbers from the first half of the year for the US and Western Europe were very disappointing.
As a result, the positive numbers out of Japan's budding recovery not enough.
A downward revision of global growth estimates has hit the markets.
As most traders know, this downward revision created a major sell-off of risky assets and a flight to quality. This creates yet another hurdle to economic recovery. Any additional bad news has traders understandably concerned.
A case in point…
The recent debt-ceiling showdown in the United States created a "crisis of competence” that undermined faith in government fiscal and monetary policy.
That increased pessimism could further slow economic growth.
It’s still too early to predict the impact that falling confidence will bring. But we do know that when assets do fall, a negative 'wealth effect' is created as investors' portfolios lose value, adding more fuel to the pessimist's fire.
Worse, recent reports from Europe and the US show drastic drops in consumer confidence and business spending. Uncertainty weighs heavily on business and consumer demand.
Given these conditions, it's easy to see why poor economic reports beget more pessimism, slower growth, and more bad economic news. Our latest predictions have GDP growth hovering close to 1% throughout the first half of 2012.
There are three major factors you will want to focus on since these they stick out the most as having the potential to cause serious trouble down the line.
Recession risks are elevated
While June and July provided some modestly positive news, the recent pessimism is more than a temporary sentiment. Reports show the pace of both US and European growth is slow. Low growth in these important economies means that even a little bad news can tilt the fragile recovery back into recession.
Current estimates for another recession are at 40% for the United States.
Significant economic growth in Asia
While GDP growth estimates are lowering across many parts of the world, Asia is showing strong growth. Japan is definitely going to continue to rebound into 2012 as the earthquake and tsunami damage skewed the numbers down temporarily.
As conditions improve, Japan should keep recovering each passing month. Asia also is not facing the same pressure for tightened fiscal policy that Europe and the US are, which means Japan has the ability to keep spending to encourage growth.
A US profit margin squeeze
As recently as late May, we argued in a special report to expect a sustained US profit margin expansion. However, with the recent changes in the markets, now profit growth has shifted downward. Because of the downward GDP trends and rising labor costs, I now expect profits to decline by a full 7% over the next 4 quarters.
What's the best way to trade in these conditions?
The trading opportunity is in the sideways movement of the EUR/USD currency pair. The two currencies are moving in parallel because both economies are on par at 1% growth rates. I expect the EUR/USD will stay within in a defined price range…
And the best way to play this is to buy when price hits the low of the range and sell or go short at the highs of that range.
The signals to watch for are a break above the previous week's high price to sell, and a break below the previous week's low to buy.
As long as these two highly correlated economies have matching slow growth, price should not break outside this range. While most trend traders will be sitting on the sidelines, you can rack up steady profits in sideways market conditions.
All good things come to an end.
This strategy assumes that the US and European growth remains at the same pace. The moment one begins to outpace the other, you need to change trading strategies. You know that eventually the market will move higher or lower outside the range into a new trend. Because of this, if you are stopped out on your first position, do not trade from that direction again.
So, if you sell at the top of the range and the market moves higher and stops you out, don't short again. Instead, wait for another opportunity if the range holds.
If you prefer a trend trade, then go short the USD/JPY as the yen strengthens along with Japan's economy against the dollar. In this case, if Japan's growth was to stall or the US economy was to surge, then you would expect that trend to reverse as well.